Friday, April 18, 2008

Will Bell Canada Deal Be Repriced?

· Synopsis: Canadian telecom market is dominated by Rogers, Bell Canada and TELUS. Largest Private Equity buyout set in motion by Ontario Teachers Pension Plan (largest Canadian Pension fund) looking to buy Bell Canada (BCE-$36.65) for $51 billion. Key issues: (a) Bondholder dispute ruled in favor of acquirers and regulatory issues over foreign ownership. (b) The $42.75 offer price represents a 6.4x EV/EBITDA multiple vs. 5.8x average multiple of telecom universe average (FactSet estimates).
· Parties Involved: Purchase- Bell Canada (BCE) by Acquirer- Ontario Teachers Pension Plan backed by Providence Equity Partners, Madison Dearborn Partners LLC, Merrill Lynch Global Private Equity and Toronto-Dominion Bank (OTPP has to have majority ownership due to regulatory requirements).
· Based on Wednesday’s closing price of $36.83, investors are looking to earn roughly 18% absolute return within this year (expected deal closing). Readers should keep in mind that while the financing required for the BCE deal to go through is enormous, big deals have closed—TXU, First Data, Alltel, and Chrysler.
· Recent Quarter Results of BCE: BCE's EBITDA grew by 5.4% vs. Q4 2006 to $1.33 billion due to cost containment, ARPU growth and lower pension costs, leading to an improvement in EBITDA margin by 120 basis points to 34.9 percent. For the FY07, EBITDA grew by 4.1% to $5.49 billion; OI grew 4.7% to $2.6 billion (higher EBITDA and lower amortization expenses were almost entirely offset by higher restructuring charges); and free cash Flow grew by 30% to $891 million due to the growth experienced in Q4. FcF for Q4 after dividends and working capital changes increased significantly to $393 million in Q4 07 vs. $200 million last year.
· Q4 overview by segments: Strong margin expansion driven by ExpressVu (5.4% YoY driven by 16.4% YoY increase in average revenue per unit but weak subscriber growth which likely made margin expansion look better as it was distributed over smaller number of subscribers. Furthermore, despite strong ARPU growth and an 11.9% YoY decline in the cost of acquiring a subscriber, wireless EBITDA margin actually declined to 35.7% in Q4/07 from 36.7% in Q4/06; Strong FcF (mentioned above); Weak residential access lines as BCE lost 117K net residential access lines in the Q.
· Key Takeaway: The absence of any alarming negative trends will leave the market comfortable that the sponsors have no reason walk from this deal from an operating results standpoint.
· Bond Holders Issue: About a month ago, the court ruled against the bondholders, but since they plan on taking the matter to higher court, I’ve included an overview of the matter prior to court ruling. The holders of Bell’s 1976 and 1996 debentures are asking the Quebec Superior Court to rule on whether the proposed privatization qualifies as a “reorganization or reconstruction” since these debentures include protection such that the trustee has the right to vote on any such change. Alternatively, BCE is countering that this deal is a “change of control” given that it was initiated by an outside party.
· Let's look at a previous case where a similar problem occurred. According to a Lawyers Weekly issue (Feb 13th, 2004- search for "bondholders debt takeover problems" in Factiva) indicates how certain 1997 Rio Algom convertible debenture holders were not successful in a similar oppression claim since there should be a reasonable expectation that a takeover could occur and that the indenture could have included provisions specifically related to such an event.
· However, if one looks at BCE's current stock price it seems that the market is discounting that bondholders arguments are gaining traction in court. That said, there is no concrete proof to support this view.
· The bondholder issue has been delayed further till June of this year. In the event that bondholders loose, we can expect them to file an appeal with Quebec Court of Appeal and the Supreme Court. The time line for this I'm expecting would be between 45-50 days
· Enough Material Adverse Change (MAC)? If the lawsuit is ruled in favor of the bondholders in any way, or if it is ruled in favor of BCE with damages awarded to the bondholders, the chance of a deal collapse increase significantly. However, it is important to note that the bondholder oppression claim does not include a request for specific damages, but the CBCA allows considerable flexibility for judges in this respect.
· OTPP has previously indicated that a damage allowance would put the deal at risk and so I assume they would use such a ruling as an excuse to break the deal, even though the offer is not conditional on bondholder approval or the outcome of this lawsuit.
· Bank Financing: No doubt we are facing a tumultuous time in the credit markets so anything is possible, but my assessment that this risk is lower than what the market thinks focuses mainly on the incentives facing these bankers, and the litigation and reputation risk of not executing.
· The banks stand to earn fees of 2-3% on the total debt being raised + future deal fees from any banking BCE does. While the banking syndicate is likely facing a $3-$6 bn writedown on the total committed debt package if the deal closes, but they stand to make $600 million to $1 billion in immediate fees and will almost certainly be sued for at least the $1 billion reverse break fee if they do not honor their commitments.
· Is the avoidance of net $1-$4 billion in writedowns for this deal worth the reputation damage for the banks? I would conjecture not because BCE involves key clients of the banks (OTPP, MLGPE, Providence Equity Partners), BCE is a stable cash generator with a current FcF yield of 8% and looking at financing for key deals going through shows good potential i.e. TXU, First Data, Alltel, Chrysler (as mentioned above).
· What If Deal Falls Through? In the event that the deal does not go through, I would expect the stock price to drop to a range between 25-27. At which point BCE will be trading in line with its closest competitor TELUS at a multiple of 11.3x 08 EPS, implying a hefty dividend yield of 5.8%.
· Since the BCE board was prepared last year at this time to commit a considerable portion of the Telesat sale ($1.89 bn net) proceeds to shareholders before the BCE was put into play, it is reasonable to assume a major share buyback as a starting point.
· BCE was sitting on almost $2.7 billion in cash at the end of fiscal 07. If we assume the BCE would be guaranteed an additional $1 billion as a result of the reverse break fee, then the cash on hand would be roughly $3.7 billion (plus any additional cash generated in Q1 2008).
· According to Scotia Capital (leading the league tables in Canada) "BCE can increase their debt leverage to 2.2 from current 1.1x EBITDA and borrow an additional $4 bn to acquire additional 16% of shares, in the process adding $3-3.5 in accretive value."
· Negotiated Lower? A few friends I have talked to in the industry inform me that this deal could be potentially repriced. So in scenario 2 I've assumed a deal price of $39 (which I've been told is quite possible if bondholders win). This assumption can be made because a) the deal was made in comparatively much better times and b) as I alluded in the overview, the $42.75 offer price represents a 6.4x EV/EBITDA multiple vs. 5.8x average multiple of telecom universe average (FactSet estimates).
· Hedge: Given the uncertainty involved in risk arbitrage, it is always a good idea to hedge one's ownership of BCE shares through an options strategy or by buying Bell Canada bonds. While the equity market fears that the BCE LBO may collapse, as evidenced by the fact that the stock is trading at a significant discount to the bid price, the bond market seems to be assuming that the deal will go through. This is evidenced by the wide Bell bond spreads.
· Key takeaway: New entrants for the time being are no threat to the big 3. One thing is guaranteed—the move to GSM networks will be the industry trend given Rogers' margins and better performance. New entries would mean a higher probability for TELUS/BCE deal going through but the time line for this I believe is long-term.

Contributor Yaser Anwar does not hold a financial position in any stocks mentioned in this article. The 10Q Detective has a Full Disclosure policy.

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